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Sector Watch: Retail REITs

Real Estate Investment Trusts (REITs) are companies that own and, typically, manage real estate investments to generate income. REITs may also invest in mortgage securities (these are called mortgage REITs or mREITs). REITs may specialize in specific types of properties. The Folio Investing Retail REIT Folio holds equal-weight allocations to the largest publicly-listed REITs that own and manage shopping centers, outlet malls, and urban retail property. Retail stores lease space from the REITs and the leases are the primary source of income.

Retail REITs have dramatically out-performed the broader market in recent years, but this sub-sector can be highly volatile.

Even considering the volatility of REITs, some experts believe that REITs are an important component of a long-term asset allocation. David Swensen, famed manager of Yale’s endowment, suggests that REITs should make up 20% of an individual investor’s portfolio. Some of our Target Date Folios hold significant allocations to REITs. The 2030 Moderate Target Date Folio, for example, currently has a 10.25% allocation to REITs.

Performance

REITs are a risky class, with the potential for substantial gains as well as big losses. Over the three years through the end of September 2012, the Retail REIT Folio gained 73% vs. a 45% gain for the S&P500 (including reinvested dividends). This level of out-performance is due to the rally in REITs over the past three years rather than any unique feature of the Retail REIT Folio.

One feature of the performance of the Retail REIT Folio that is notable is the divergence of Retail REITs from broader REIT indexes. Over the twelve months through September 2012, the Retail REIT Folio has returned 42.7% vs. 32.3% for Vanguard’s REIT Index ETF (VNQ).

The recent out-performance of Retail REITs is especially interesting in light of the growth of online retail sales. More purchasing online would seem to reduce the profitability of bricks-and-mortar retail stores, not least because of the current advantage that online retailers have with regard to collecting sales tax. The impacts of online retailing on the profitability of retail REITs have not been robustly analyzed, however.

Industry Overview

Retail REITs operate in a rapidly changing business environment. The ways that people purchase goods and services is increasingly empowered by online tools, whether or not the actual transaction is online. The enormous popularity of Apple stores is a case in point. Apple stores average $40 Million in average sales and they are selling products that seem ideally suited for online purchase. It is also important to understand that even with the ubiquity of smart phones and online retailing, only 9% of retail purchases are made online.

The vast majority of retail spending takes place at a specific store or restaurant. The profitability of Retail REITs is principally determined by the rental rates for retail space. Rentals rates are driven by many factors. For rental rates to rise, retail stores must have the financial resources and positive outlook to expand. The demand for retail space, while lower than before the market downturn in 2008, has increased in the last twelve months.

It is also likely that the substantial price appreciation from REITs and Retail REITs in particular, is partly due to investors seeking income in the current low-yield environment. The Retail REIT Folio has a current 12-month yield of 3.94%.

Source: Folio Investing
[Note: The holdings are re-evaluated and updated (as needed) on a quarterly basis.]

Commentary

There are a number of good reasons for investors to consider REITs. First, REITs are an important asset class in an overall asset allocation plan, providing diversification benefits. Second, REITs tend to provide some protection from inflation because rental rates tend to go up with inflation. Finally, REITs often provide income levels well above most other asset classes. Investors need to understand, however, that REITs can be very volatile. The high returns of recent years come after a major decline in returns when the last real estate bubble burst.

REITs are a high risk / high return asset class. They have a place in a well-diversified portfolio. The out-performance of Retail REITs in the last twelve months, and the broader out-performance of REITs as a whole over the past three years, is part of the increased upside potential of this volatile asset class. Investors need to be cognizant of the substantial risk levels associated with REITs however. Income investors, in particular, should be wary of choosing to own REITs on the basis of their yield unless they also have a firm understanding of the associated risks.

About Geoff Considine

After earning his Ph.D. in Atmospheric Science, Geoff worked for NASA for 3 years, leaving to become a quantitative analyst developing trading and portfolio management solutions for an energy trading firm. In 2000, Geoff became a consultant focusing on quantitative methods in portfolio management. Geoff founded Quantext in March 2002.
Geoff has published commentary and analysis in a range of publications.
Quantext is a strategic adviser to FOLIOfn,Inc. (www.foliofn.com (http://www.foliofn.com)).
Neither Quantext nor Geoff Considine is an investment advisor.

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